KFC, Pizza Hut expanding to China's smaller cities

The owner of KFC and Pizza Hut is bringing its fast-food menus to new parts of China, with plans to set up shop in smaller cities throughout the country.

After establishing itself in China's biggest cities in recent years, Yum Brands Inc. is focusing on populating the country's less urbanized regions. Building that infrastructure in those outposts of the developing nation will give it the kind of advantage that McDonald's established decades ago in the U.S., CEO David Novak said at the company's investor conference Thursday.

Yum, which also owns Taco Bell in the United States, is already the biggest Western fast-food chain in China, with about 5,400 locations, compared with 1,600 for McDonald's. The nation's economic growth has been a boon for Yum, helping it register an annual profit growth of at least 10 percent over the last several years. But with competition intensifying and economic growth slowing, Yum has hit a snag as well.

Last week, Yum said it expects a key sales figure to fall 4 percent in China in the fourth quarter, marking its first decline since 2009. A year earlier, sales at established restaurants had surged 21 percent.

Also pressuring results in China are the company's rising labor and rental costs in big cities such as Shanghai, Beijing, Guangzhou and Shenzhen. As a result, the company said it would be more selective about its expansion in such metropolitan areas.

But executives noted that there is still plenty of room for growth in smaller cities, with the Chinese government investing heavily in transportation infrastructure. While Yum has nine restaurants for every 1 million people in larger cities, it has just two per million people in smaller cities.

Within the first three years of opening, the company noted that new restaurants in smaller cities bring in sales of about $1.4 million to $1.5 million, showing there's an appetite for its food even less urbanized areas of China.

"We're only on the ground floor of China's development opportunity," said Weiwei Chen, Yum's chief financial officer of China.

In 2013, Yum plans to build 700 restaurants in China. This year, the company had predicted it would build 650 but ended up building more than 800.

To cultivate loyalty in an increasingly competitive landscape, Yum is working to stay relevant to local tastes. This year, for example, the company introduced rice as a side dish in KFC. Next year, it plans to extend the line with premium rice offerings.

Although KFC accounts for the bulk of its business in China, Yum is also expanding its Pizza Hut chain, doubling the number of openings next year to 220. That's about the same number of restaurants McDonald's is expected to build in the country, Chen noted.

Part of the pizza chain's growth will be fueled by its expanding delivery service. The company noted that its name for the service translates to "Must Win Homes Fast Delivery" in Chinese— and does not include the word "pizza," which is not as widely eaten in the country as in the U.S. Non-pizza food accounts for about half of sales at Pizza Huts in China.

In addition to its flagship U.S. brands, Yum has two smaller Chinese food chains — East Dawning and Little Sheep. Chen noted those chains are important to the company because "the Chinese consumer will always eat more Chinese food than western food."

Overall, Yum expects growth to be in the mid-single digits in China for 2013. Growth is expected to be softer in the first half of the year, and pick up in the second half.

Beyond China, Yum sees India as its next big region for growth. It also noted that it also has a bigger presence than McDonald's in other developing nations, such as South Africa. And about half its operating profits now come from emerging markets, compared with 40 percent in 2009.